Investing vs Speculating: A Bitcoin Story
In our most recent quarterly letter, we talked about uncertainty in the markets and how we choose when and where to take risks. We described our preference for investments where we don’t have to make a lot of accurate predictions in order to have a good outcome. In the past, you could have just called this “investing” but today, speculative activities that pay no heed to this conservatism are being undeservingly classified as the same.
This isn’t anything new. History is littered with examples of times when the line between investing and speculating has become blurred – tulip bulbs, 1980s Tokyo real estate, baseball cards, beanie babies, dotcom companies, 2000s Florida real estate, and most recently, the Bitcoin craze, which seems to be the latest incarnation of the “limited supply equals value” speculative mistake. There’s a limited supply of Globescan branded coffee cups in the world (roughly 4 in our office) but that doesn’t mean we see ourselves flipping them for a profit any time soon (we are accepting bids).
To set the scene, let’s revisit a great analogy popularized by Seth Klarman in his book Margin of Safety:
There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines."
Like these sardine traders, many market participants today are forgetting their original purpose. They are trading in and out of stocks simply as numbers on a screen rather than as ownership stakes in real businesses, and worst of all they are not doing the hard work of actually understanding what it is they are buying and whether or not it will make them sick.
Investing vs Speculating
When you invest, you allocate capital thoughtfully and carefully in specific assets that you think will generate a positive return. This involves analyzing the fundamentals of the company or asset in question. This detailed research helps to discover situations where the odds of a good outcome (based on the fundamental characteristics of the investment) outweigh the odds of a bad outcome.
Speculation or trading involves buying an asset in the hope that someone else will pay more for that same asset in the future. Your odds of a good outcome rely on how well you can predict specific outcomes, events, or the behavior of other, often irrational, individuals. Those who make these ‘predictions’ often base them on past patterns which themselves are altered by the act of speculation, like trying to hit a target when the simple act of aiming moves the target.
Bitcoin: As Far from Investing as You Can Get
Probably the most striking example of recent speculation run amok is the idea of Bitcoin as an investment. If you haven't heard, Bitcoin has made somewhat of a resurgence this year, up 188% YTD after being down about 75% in 2018. In reality, for most of these Bitcoin buyers, the fundamental attraction here is the wishful idea that investing and getting rich should be easy.
Bitcoin proponents would argue that it is a legitimate investment for three key reasons:
It’s a decentralized and independent currency that the Government can’t devalue as they go deeper and deeper into debt. This idea is the result of a fundamental misunderstanding of what money is and how the economy works. Money isn’t something we have. Productivity is something we have, money is something we can get. Money is credit. All major currencies today are fiat currencies. Have a good business idea? A bank will create a deposit asset for you out of thin air that you can use for building up that idea. If it works, pay them back and the economy now has an enterprise that wouldn’t otherwise exist. There is no reason that this transaction needs to be artificially fixed to how much currency or metal is available in a given system. Instead, the money supply should (and does) expand or contract with the supply of productive endeavors in an economy. A fixed currency leads to deflation and hoarding.
Restricted Supply – Similar to gold, there is a theoretical limit to the number of Bitcoins that will ever exist, about 21 million. But remember our GCI mug example- scarcity itself does not equal value. Also, for an asset with a main selling point of restricted supply, there is certainly no dearth of other cryptocurrencies to invest in. In fact, Bitcoin isn’t even the best performing cryptocurrency this year- Binance Coin, Tezos, Litecoin, and Bitcoin Cash are all up more. It is no coincidence that the largest cryptocurrencies by market cap are the ones that people have the easiest access to on Coinbase. It follows that as more people gain access to different cryptocurrencies, the price of each will be diluted.
Blockchain – this is a revolutionary distributed ledger that allows people to transact with each other over the internet even when they don’t trust each other. But it also happens to be a free and open source technology. A useful analogy is the internet itself. Back in the 1990s, it was very clear that there was a ton of value in the internet. Certain companies jumped on the wave and were handsomely rewarded for doing so, but there was nothing stopping competitors from doing the same. Some of these competitors innovated and built upon the work of those that came before them, and some of these competitors just added dotcom to their name and ran away with the money. Like the internet, the blockchain is open to innovators and scammers alike. There is no reason Bitcoin must be the winner here long-term just for being first.
We could talk about of a lot of other issues here – energy efficiency, security, government regulation (this is a huge barrier), but what does any of this matter if everyone is still getting rich off Bitcoin? The truth is there will always be something returning 100x. There will always be someone winning the lotto. The hardest part of any cycle is when everyone else seems like they are getting rich. This is when we need take a step back and compare the narrative to the reality. As Buffett likes to say, “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
We have chosen to pick on Bitcoin, but the truth is the same speculative thinking that happens in the cryptocurrency market also happens in the equity markets that we invest in. Often, the value assigned to good companies includes an expectation of future growth or margin expansion that proves to be too optimistic in good times, and too pessimistic in bad times.
Our job is to do the hard, time-intensive work of figuring out the true underlying economics of each of our investments. It is only then that we can know when the speculators are bidding prices too high or selling them too low. And even if we don’t get this timing exactly right (which we often won’t) over long periods of time the starting valuation matters less and less, while the quality of the underlying business matters more and more.
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